global financial enviornment

P A R T 1

Global FinancialEnvironment

Part 1 is an introduction to the global financial environment in which the multi-national enterprise (MNE) exists.

CHAPTER 1 describes the globalization process experienced by Trident, a hypo-thetical MNE that is used as an example throughout the book. It starts as adomestic firm, enters the international trade phase, and then expands its opera-tions to an overseas location, thereby becoming an MNE. During this global-ization process, Trident’s management must understand the theories andactivities introduced in Chapter 1 and explained in the rest of this book. Thus,we eventually examine foreign exchange theory and markets, foreign exchangeexposure and management, financing the global firm, the foreign investmentdecision, and management of working capital, taxes, and international tradefinance. Chapter 1 continues with an analysis of management goals. Thisinvolves a description of the shareholder versus corporate wealth maximizationbehavior, corporate operational goals, corporate governance, failures in corpo-rate governance, and reform.

CHAPTER 2 defines currency terminology. It describes the history of the inter-national monetary system from 1876 to the present. It introduces theEurocurrency market and LIBOR. It then compares contemporary currencyregimes (systems) and the special case of emerging market currency regimes,including currency boards and dollarization. Chapter 2 concludes with adetailed examination of European monetary unification resulting in the launchof the new currency — the euro.

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2 PART 1 | Global Financial Environment

CHAPTER 3 examines the balance of payments.We analyze each account and the mostimportant summary accounts. It explains why the balance of payments always “balances.” It then presents the detailed U.S. balance of payments accounts for the1998–2002 period. It concludes with an analysis about how the balance of paymentsinteracts with such key macroeconomic variables as gross domestic product, theexchange rate, interest rates, and inflation rates.

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C H A P T E R 1

Financial Goalsand Corporate

Governance

L E A R N I N G O B J E C T I V E S

Consider how the globalization process moves a businessfrom a purely domestic focus in its financial relationshipsand composition to one truly global in scope

Learn what the implications of phase one of globalization —the international trade phase — means for the risks andreturns of a business

Discover what three major corporate currency exposuresarise from multinational business

Examine how the continuing globalization process extendsfrom international trade to multinational operations toglobal activities

Examine how financial and operational goals are perceivedin a global context

See how globalization affects corporate governance of theorganization and how it creates value for its stakeholders

Investigate failures in global corporate governance

3

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This book is about international financial management with special emphasis on themultinational enterprise (MNE). The MNE is defined as one that has operating sub-sidiaries, branches, or affiliates located in foreign countries. It also includes firms inservice activities such as consulting, accounting, construction, legal, advertising, enter-tainment, banking, telecommunications, and lodging.

MNEs are headquartered all over the world. Many of them are owned by a mix-ture of domestic and foreign shareholders.The ownership of some firms is so dispersedinternationally that they are known as transnational corporations. The transnationalsare usually managed from a global perspective rather than from the perspective of anysingle country.

Although Fundamentals of Multinational Finance emphasizes MNEs, purelydomestic firms also often have significant international activities. These include theimport and export of products, components, and services. Domestic firms can alsolicense foreign firms to conduct their foreign business. They have exposure to foreigncompetition in their domestic market. They also have indirect exposure to interna-tional risks through their relationships with customers and suppliers. Therefore,domestic firm managers need to understand international financial risk, especiallythose related to foreign exchange rates and the credit risks related to trade payments.

Fundamentals of Multinational Finance is written in English and usually uses theU.S. dollar in its exposition. However, the authors have tried to make it relevant for allmultinational enterprises by using numerous non-U.S.-based MNEs. We use the termmultinational enterprise throughout this text for two very important reasons. First, theterm multinational is used rather than international because we focus on the thirdphase of the globalization process, in which firms operate businesses in many differentcountries. Secondly, we use the term enterprise instead of corporation because as busi-nesses move into many emerging markets, they enter into joint ventures, strategicalliances, or simply operating agreements with enterprises which may not be publiclytraded or even privately owned (and therefore not corporations), but actually exten-sions of government.

What Is Different About Global Financial Management?

Exhibit 1.1 details some of the main differences between international and domesticfinancial management. These component differences include institutions, foreignexchange and political risks, and the modifications required of financial theory andfinancial instruments.

International financial management requires an understanding of cultural, histor-ical, and institutional differences such as those affecting corporate governance.Although both domestic firms and MNEs are exposed to foreign exchange risks,MNEs alone face certain risks that are not normally a threat to domestic operationssuch as political risks.

MNEs also face other risks that can be classified as extensions of domestic financetheory. For example, the normal domestic approach to the cost of capital, sourcing debtand equity, capital budgeting, working capital management, taxation, and credit analy-sis needs to be modified to accommodate foreign complexities. Moreover, a number offinancial instruments that are used in domestic financial management have been mod-ified for use in international financial management. Examples are foreign currencyoptions and futures, interest rate and currency swaps, and letters of credit.

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5Chapter 1: Financial Goals and Corporate Governance

Concept International Domestic

Culture, history, and Each foreign country is unique and Each country has a known environment.

institutions not always understood by MNE Base case.

management.

Corporate governance Foreign countries’ regulations and Regulations and institutions are well known.

institutional practices are all uniquely

different.

Foreign exchange risk MNEs face foreign exchange risks Foreign exchange risks arise from import/

due to their subsidiaries, as well as export and foreign competition, but not

import/export and foreign competitors. from subsidiaries.

Political risk MNEs face political risks because of Political risks are negligible.

their foreign subsidiaries and high profile.

Modification of domestic MNEs must modify finance theories Base case.

finance theories like capital budgeting and cost of

capital because of foreign complexities.

Modification of domestic MNEs utilize modified financial instruments Base case.

financial instruments such as options, futures, swaps, and letters

of credit.

EXHIBIT 1.1What Is Different About International Financial Management?

The main purpose of this book is to describe and analyze how a firm’s financialmanagement tasks evolve as it pursues global strategic opportunities and new con-straints emerge. In this opening chapter, we take a brief look at the challenges and risksassociated with a company evolving from domestic in scope to being truly multina-tional. This will include the constraints that a company will face in terms of managerialgoals and governance as it becomes increasingly involved in multinational operations.In the rest of this chapter we examine how cultural, historical, and institutional differ-ences affect a firm’s choice of financial goals and corporate governance.

The Globalization Process

Trident Corporation (Trident) is a hypothetical U.S.–based firm that will be used as anillustrative example throughout the book to demonstrate the globalization process.The globalization process is the structural and managerial changes and challengesexperienced by a firm as it moves from domestic to global in operations.

Global Transition I: Trident Moves from the Domestic Phase to theInternational Trade Phase

Trident is a young firm that manufactures and distributes an array of telecommunicationdevices. Its initial strategy is to develop a sustainable competitive advantage in the U.S.market. Like many other young firms it is constrained by its small size, other competi-tors, and lack of access to cheap and plentiful sources of capital. The top half of Exhibit1.2 shows Trident in its early domestic phase. Trident sells its products in U.S. dollars toU.S. customers and buys its manufacturing and service inputs from U.S. suppliers, payingU.S. dollars.The creditworth of all suppliers and buyers is established under domestic U.S.

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Mexican Suppliers Canadian Buyers

Are Mexican suppliersdependable?

Will Trident pay US$ orMexican pesos?

All payments in U.S. dollars.All credit risk under U.S. law.

Are Canadian buyerscreditworthy?

Will payment be madein US$ or C$?

Trident Corporation(Los Angeles, USA)

Phase Two: Expansion into International Trade

U.S. Suppliers(domestic)

U.S. Buyers(domestic)

Phase One: Domestic Operations

EXHIBIT 1.2Trident Corp:

Initiation of theGlobalization

Process

practices and procedures.A potential issue for Trident at this time is that although Tridentitself is not international or global in its operations, some of its competitors or suppliersor buyers may be. This is often one of the key drivers to push a firm like Trident into thefirst transition of the globalization process, the international trade phase.

Trident was founded by James and Edgar Winston in Los Angeles in 1948 to maketelecommunications equipment. The family-owned business expanded slowly butsteadily over the following 40 years. The demands of continual technological invest-ment in the 1980s, however, required that the firm raise additional equity capital inorder to compete. This need led to its initial public offering (IPO) in 1988. As a U.S.–based publicly traded company on NASDAQ, Trident’s management sought to createvalue for its shareholders. Issues related to the goals and control of multinationalenterprises are discussed in more detail later in this chapter.

As Trident became a visible and viable competitor in the U.S. market, strategic oppor-tunities arose to expand the firm’s market reach by exporting products and services to oneor more foreign markets. The North American Free Trade Agreement (NAFTA) madetrade with Mexico and Canada attractive. This second phase of the globalization processis depicted in the lower half of Exhibit 1.2.Trident responded to these globalization forcesby importing inputs from Mexican suppliers and making export sales to Canadian buyers.We define this stage of the globalization process as the international trade phase.

Exporting and importing products and services increases the demands of financialmanagement over and above the traditional requirements of the domestic-only busi-ness. First, direct foreign exchange risks are now borne by the firm. Trident may nowneed to quote prices in foreign currencies, accept payment in foreign currencies, or paysuppliers in foreign currencies. As the value of currencies change from minute tominute in the global marketplace, Trident will now experience significant risks fromthe changing values associated with these foreign currency payments and receipts.

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GreaterForeignInvestment

GreaterForeignPresence

Production Abroad

Control AssetsAbroad

Wholly-OwnedSubsidiary

Acquisition of a Foreign Enterprise

Exploit Existing CompetitiveAdvantage Abroad

Production at Home:Exporting

LicensingManagement Contract

Joint Venture

GreenfieldInvestment

ChangeCompetitive Advantage

Trident and ItsCompetitive Advantage

EXHIBIT 1.3Trident’s Foreign

Direct InvestmentSequence

Second, the evaluation of the credit quality of foreign buyers and sellers is nowmore important than ever. Reducing the possibility of non-payment for exports andnon-delivery of imports becomes one of two main financial management tasks duringthis international trade phase. This credit risk management task is much more difficultin international business, as buyers and suppliers are new, subject to differing businesspractices and legal systems, and generally more challenging for Trident to assess.

Global Transition II: The International Trade Phase to the Multinational Phase

If Trident is successful in its international trade activities, the time will come when theglobalization process will progress to the next phase. Trident will soon need to estab-lish foreign sales and service affiliates. This step is often followed by establishing man-ufacturing operations abroad or by licensing foreign firms to produce and serviceTrident’s products. The multitudes of issues and activities associated with this secondlarger global transition is the true purpose of this book.

Trident’s continued globalization will now require it to identify the sources of itscompetitive advantage, and with that knowledge in-hand, expand its intellectual capi-tal and physical presence globally. A variety of strategic alternatives are available toTrident — the foreign direct investment sequence — as illustrated in Exhibit 1.3. Thesealternatives include the creation of foreign sales offices or the licensing of everythingfrom its name to the manufacturing and distribution of its products to other firms inforeign markets. As Trident moves further down and to the right in Exhibit 1.3, thedegree of its physical presence in foreign markets increases. It may now own its own

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distribution and production facilities, and ultimately, may find it wishes to own othercompanies which they acquire. Once Trident owns assets and enterprises in foreigncountries it has entered the multinational phase of its globalization.

PART I: THE GLOBAL FINANCIAL ENVIRONMENT

But as Trident moves further down and to the right in this multinational phase, it bearsgreater risks, which arise from multinational activities. The foreign exchange risks andcredit management risks suffered by Trident now only grow. In order to identify andmanage its foreign currency risks, Trident must first develop a background knowledgeof the global financial environment that influences the value of currencies. The inter-national monetary system and the balance of payments are discussed in Chapters 2 and3 of this book.

PART II: FOREIGN EXCHANGE THEORY AND MARKETS

Trident’s financial managers must now understand how foreign exchange rates aredetermined so they can develop some feel for forecasting exchange rates. This is thesubject of Chapters 4 and 5. Trident’s management must also understand the institu-tional processes of how currencies are traded on world markets in order to undertakethe currency trading activities needed to manage its growing global operations. This iscovered in Chapter 6.

The task of forecasting foreign exchange rates is a subjective one and often yieldsunsatisfactory results. Therefore, Trident’s financial management must know whatinstruments exist that can reduce foreign exchange risks, regardless of whether or notexchange rates can be correctly forecast in practice. Trident’s financial managers willneed to become adept in the use of various financial instruments and derivatives usedto manage many of these foreign exchange rate and interest rate risks. This is the sub-ject of Chapter 7.

PART III: FOREIGN EXCHANGE EXPOSURE MEASUREMENT ANDMANAGEMENT

Part III of the text reaches directly into the core of multinational business and its finan-cial management, as Trident is now faced with three major sources of foreign exchangeexposure. The fact that more and more of Trident’s cash flows are denominated in for-eign currency presents a significant risk that must be managed. This foreign exchangerisk is called transaction exposure and is the subject of Chapter 8.

As the globalization process continues, Trident’s financial management tasksbecome considerably more complex. Foreign currency transaction exposures (Chapter8) now include foreign exchange risks generated by Trident’s ownership of foreignsales, manufacturing, and service subsidiaries. Because Trident’s value as a firm willnow vary with future unexpected changes in exchange rates, its operating exposure —its long-term competitiveness and ability to generate cash flows — becomes a majorconcern for management. The topic of operating exposure is the subject of Chapter 9.

The final major currency exposure that Trident faces is translation exposure.Translation exposure, sometimes referred to as accounting exposure, arises from theprocess of restating the foreign currency-denominated financial statements of Trident’sforeign subsidiaries into the home currency (the U.S. dollar) for reporting purposes. Inorder for Trident’s global operations to be reported to stockholders and creditors, itmust be able to measure global financial results in a single currency. The consolidationprocess and the exchange rate risks associated with it are analyzed in Chapter 10.

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PART IV: FINANCING THE GLOBAL FIRM

As Trident prospers and grows larger at home and abroad, it begins to confront a sig-nificant constraint to further growth — access to cheap and plentiful capital. This cap-ital constraint prevents it from competing with its global competitors, as they haveaccess to larger quantities of capital at lower cost. Trident can overcome this constraintby gaining access to global equity and debt markets while maintaining an optimalfinancial structure (the ratio of debt to equity in the company as a whole). The strategyof globalizing the cost and availability of capital is a critical one for firms wishing toreach true global competitiveness. The issues and opportunities in implementing thisstrategy are covered in Chapters 11–14. This analysis will include the current debate asto whether multinational enterprises have a lower or higher cost of capital than theirdomestic counterparts.

PART V: FOREIGN INVESTMENT DECISIONS

Trident Corporation’s foreign investment decisions combine strategy and finance.Trident’s global expansion is creating a portfolio of international assets. The manage-ment of Trident, as well as its current and potential shareholders, need to understandthe risks and rewards of global portfolio diversification. This is analyzed in Chapter 15.

As Trident Corporation seeks to implement foreign direct investment, as shown inExhibit 1.3, fundamental strategic questions need to be answered. What is Trident’scompetitive advantage and is it transferable abroad? Does a foreign investment trulybuild value for shareholders? If it wishes to produce abroad should it attempt to con-trol the assets or does it prefer to license another firm? If it wishes to control the assetsshould that control be through a wholly owned subsidiary or through a joint venture?These strategic questions are analyzed in Chapter 16.

Foreign direct investment will subject Trident to additional political and countryrisks. Trident may face risks that are firm-specific and controllable. However, it mayalso face risks that are country-specific and global-specific and uncontrollable. Theserisks are the subject of Chapter 17.

As is the case for domestic capital projects, Trident must analyze and evaluate allproposed new foreign-located projects using a capital budgeting framework.This finan-cial management task becomes extremely complex since foreign projects involveanalysis of foreign inflation, foreign exchange risks, blocked funds and other politicalrisks, method of financing, expected cash flows to both the project and the parent(Trident Corporation), guesstimates of the project’s terminal value in both local cur-rency and parent currency terms, and other complications. Capital budgeting is ana-lyzed in Chapter 18.

We will follow Trident as it invests in a variety of forms around the world (seeExhibit 1.4). Trident’s first step in the implementation of its strategic plan is to build anew manufacturing and distribution center in Germany. This is typically termed agreenfield investment because prior to construction there was nothing there but a greenfield. It is most likely a long-term investment in business services or productive capa-bilities. The company follows this foreign expansion with the acquisition of an existingcompany in Brazil. Cross-border acquisitions are typically preferred when the acquisi-tion target has capabilities which a firm like Trident cannot duplicate (for examplethrough greenfield investing). The Brazilian investment was followed by the creationof a joint venture in China, in which Trident agreed to share investments and earningswith a partner. In many of the world’s emerging markets, like China, a foreign multi-national firm like Trident is not allowed to hold sole ownership of enterprises withouta local partner.

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Trident Europe(Hamburg, Germany)


Joint VentureInvestment

Trident Brazil(São Paulo, Brazil)

Trident China(Shanghai, China)

A long-term physicalinvestment in

productive capabilityin that country

Identification,valuation, tender,

and post-acquisitionmanagement of an

existing going concern

Combining investmentcapital and managerial

know-how to reachspecific opportunities


Cross-BorderAcquisition

Joint VentureInvestment

Cross-BorderAcquisition


EXHIBIT 1.4Trident’s

Potential Risksand Returns

Multiply withGlobal

Operations

Valuation Issues Governance Issues

What is the company‘sglobal expansion strategy?

What is the company willing to pay to pursue its strategy?

Does the foreign investmenttruly build value for

shareholders?

Will the new business unit standon its own or be integrated with

global operations?

What are the expectedlocal currency cash flows

to occur over time?

What are theseexpected cash flows

worth in U.S. dollars?

Who currently owns it? Is it a privatization, a divestiture,

a greenfield investment?

Will the project bewholly-owned or a

joint venture?

Analysis of ForeignInvestment or Acquisition


EXHIBIT 1.5Trident’s

Evaluation ofGlobal

Investments

The financial management tasks associated with these international investmentactivities are again different than those conducted domestically. Trident would nowneed to conduct a cross-border valuation for any prospective acquisition target. Afteracquisition, Trident would need to assure a successful integration of any acquisitioninto Trident’s global operations. This is often constrained by different corporate cul-tures and styles of corporate governance, and may confront Trident with a complex setof post-acquisition management challenges. Exhibit 1.5 presents some of these issues

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Trident USA(Los Angeles, USA)

Trident China(Shanghai, China)

Trident Europe(Hamburg, Germany)

Trident Brazil(São Paulo, Brazil)

Currency:Tax rate:2004 earnings before tax (EBT): $4.5 million

US dollar ($)35%

Currency:Tax rate:2004 EBT:Avg exchange rate:2004 EBT in US$:

Euros (€)45%

€ 4.5 million$1.20/€

$5.4 million


Chinese renminbi (Rmb)30%

(Rmb 2.5 million)Rmb 8.27/$

($0.302 million)


Brazilian real (R$)25%

R$ 6.25 millionR$ 3.00/$

$2.083 million


EXHIBIT 1.6The Currency andTax Environments

of TridentCorporation and

Its ForeignSubsidiaries

related to global investment valuation and governance. The international acquisitionand valuation process is the subject of the chapter available on this book’s web-site.

PART VI: MANAGING MULTINATIONAL OPERATIONS

The globalization process for Trident has to this point focused on how it has expandedits global scope and depth of operations. Financial management associated with thedaily management of global operations, however, is not trivial; this is the subject of thefinal section of this book. Chapter 19 describes the processes involved in conductinginternational transactions in foreign trade, including contracts, documents, and proce-dures. It also analyzes how trade can be financed by using bankers’ acceptances andother specialized instruments.

Managerial strategies and tactics employed by Trident for the reduction of itsglobal tax liabilities include, among other techniques, the use of transfer pricing (theprices charged on sales of goods and services between units of Trident itself globally),assessment of charges for intellectual capital used by foreign subsidiaries owned by theparent company — royalties and license fees, and differing financing structures. Tridentmust also consider the impact on taxation and the potential for blocked funds (gov-ernmental regulations that hinder the movement of capital out of a country) whenchoosing strategies that reposition earnings and cash flows. This is the subject ofChapter 20, tax management. Trident’s currency and tax environments are shown inExhibit 1.6.

The financial management of working capital is a very important yet complex taskfaced by Trident’s management as the scope of its global business expands. Workingcapital management combines the cash, accounts receivable, inventories, accountspayable, short-term loans and access to banks, and other ongoing revenues andexpenses associated with the day-to-day operations of each and every business unitaround the globe. Working capital practices are integrally associated with the cultural

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and traditional business practices within each host country as well as the level of eco-nomic development and sophistication of the social and industrial infrastructure. Thecomplexity of Trident’s global supply chain will require astute financial managementand an integration of finance with procurement, logistics, global supplier management,and marketing. These issues and the associated management strategies that Tridentmight employ across global operations are the subject of Chapter 21.

What Is the Goal of Management?

As Trident becomes more deeply committed to multinational operations, a new con-straint develops, one that springs from divergent worldwide opinions and practices as tojust what the firms’ overall goal should be from the perspective of top management:

What do investors want? First, of course, investors want performance: strong pre-dictable earnings and sustainable growth. Second, they want transparency, account-ability, open communications and effective corporate governance. Companies thatfail to move toward international standards in each of these areas will fail to attractand retain international capital.

“The Brave New World of Corporate Governance,”Latinfinance, May 2001.

An introductory course in finance is usually taught within the framework of maximiz-ing shareholders’ wealth as the goal of management. In fact, every business studentmemorizes the concept of maximizing shareholder value somewhere in his or her col-legiate education. This rather rote memorization, however, has at least two major chal-lenges: (1) it is not necessarily the accepted goal of management across countries tomaximize the wealth of shareholders — other stakeholders may carry substantialweight, and (2) it is extremely difficult to carry out. Creating value is — like so manylofty goals — much easier said than done. One must realize that the so-called universaltruths taught in basic finance courses are actually culturally determined norms.

SHAREHOLDER WEALTH MAXIMIZATION

The Anglo-American markets are characterized by a philosophy that a firm’s objectiveshould be to maximize shareholder wealth. Anglo-American is defined to mean theUnited States, United Kingdom, Canada, Australia, and New Zealand. This theoryassumes that the firm should strive to maximize the return to shareholders — thoseindividuals owning equity shares in the firm, as measured by the sum of capital gainsand dividends, for a given level of risk. This in turn implies that management shouldalways attempt to minimize the risk to shareholders for a given rate of return.

This shareholder focus has a tendency to assume that stock markets — the mar-kets in which the individual shares of ownership of these firms are listed and tradedbetween investors — are efficient. Efficiency in the field of finance has a very strict setof meanings, including the assumption that the market share price is typically “correct”because it captures all or most of the expectations of return and risk as seen byinvestors. The theory also assumes that the market moves quickly to incorporate allnew information in the share price.And, in the end, it assumes that share prices are thebest allocators of capital in the macro economy.

The shareholder wealth theory also defines risk in a very strict financial sense. Riskis defined as the added risk that the firm’s shares bring to a diversified portfolio,

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1Gordon Donaldson and Jay Lorsch, Decision Making at the Top: The Shaping of Strategic Direction, NewYork: Basic Books, 1983, pp. 162–163.

systematic risk. The total operational risk of the firm can be eliminated through port-folio diversification by the investors. Thus, unsystematic risk, the risk of the individualsecurity, should not be a prime concern for management unless it increases theprospect of bankruptcy. Systematic risk, the risk of the market in general, cannot beeliminated. This reflects risk that the share price will be a function of the stock market.

CORPORATE WEALTH MAXIMIZATION

Horoshi Suzuki’s first day on the job as president of Hoya Corporation differedfrom most senior management appointments. The company’s board of directorsasked him to sit down and write down the name of his successor. “What they weretelling me is if I screw up, I’ll be out,” says Suzuki with a smile.

“Day of the Shareholder,” Far Eastern Economic Review, September 13, 2001.

The above definitions of return and risk are not universally accepted, and the experi-ence of Horoshi Suzuki is not always the norm. In contrast to the shareholder focus,Continental European and Japanese markets are characterized by a philosophy that allof a corporation’s stakeholders should be considered, and the objective should be tomaximize corporate wealth. Thus a firm should treat shareholders on a par with othercorporate stakeholders, such as management, labor, the local community, suppliers,creditors, and even the government. The goal is to earn as much as possible in the longrun, but to retain enough to increase the corporate wealth for the benefit of all. Thismodel has also been labeled the stakeholder capitalism model.

The definition of corporate wealth is much broader than just “financial wealth.” Itincludes the firm’s technical, market, and human resources. This means that an MNEthat believes it must close a manufacturing facility in Stuttgart, Germany, and shift itsoperations to Penang, Malaysia, may not do so without considering the employmentand other social impacts on the Stuttgart community. As one study put it, “[Corporatewealth] goes beyond the wealth measured by conventional financial reports to includethe firm’s market position as well as the knowledge and skill of its employees in tech-nology, manufacturing processes, marketing and administration of the enterprise.”1

The corporate wealth philosophy does not assume that equity markets are eitherefficient or inefficient. It does not really matter because the firm’s financial goals arenot exclusively shareholder-oriented. In any case, the model assumes that long-term“loyal” shareholders should influence corporate strategy, not the transient portfolioinvestor. The stakeholder capitalism theory assumes that total risk — that is, operatingand financial risk — does count. It is a specific corporate objective to generate grow-ing earnings and dividends over the long run with as much certainty as possible, giventhe firm’s mission statement and goals. Risk is measured more by product market vari-ability than by short-term variation in earnings and share price. Exhibit 1.7 provides asimplified comparison of the stakeholder and shareholder wealth maximization theo-ries. Note that “the firm” is defined in a physical sense as its management.

There are, however, primary stakeholders in both the shareholder wealth and cor-porate wealth maximization models. These primary stakeholders are those individualsor entities that directly influence the development and implementation of the corpo-rate strategy. In the Anglo-American markets, the primary stakeholders are clearly theshareholders. Management, those employed to act on behalf of shareholders (theiragents), is positioned between shareholders and those providing debt capital to the

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Anglo-American Model

Firm(management)

”Impatient Capital”

The Anglo-American Model has been frequently criticized as focusing on short-term profitability rather than long-term growth.

Shareholders Shareholders

Banks

The Non–Anglo-American Model has come under increasing criticism forits lack of accountability to equity investors—its shareholders—while focusing on the demands of too diffuse a group of stakeholders.

Employees

Non–Anglo-American Model

Firm(management)

”Patient Capital”

Main Bank

EXHIBIT 1.7The Corporate

Wealth andShareholder

WealthMaximization

Models asPracticed in

Anglo-Americanand Non–Anglo-

AmericanMarkets

firm, and the markets in which the firm offers its goods and services. Management isexpected to make decisions that build value (generate earnings and hopefully capitalappreciation) for shareholders. Although creditors and employees and other stake-holders must be considered, they are clearly of secondary importance. Financial profitis the goal and is often termed impatient capital.

Corporate wealth maximization as practiced in the European and Japanese mar-kets combines the interests and inputs of shareholders with creditors, management,employees, and society. This is obviously a much more complex process and typicallyresults in an organization which moves more slowly and carefully. In the simplifiedform illustrated in Exhibit 1.7, the firm is a combination of these groups. The deliber-ateness of the process demonstrated in the European and Japanese governance systemhas sometimes been termed patient capital.

Although both forms of wealth maximization have their strengths and weaknesses,two trends in recent years have led to an increasing focus on the shareholder wealthform. First, as more of the non–Anglo-American markets have increasingly privatizedtheir industries, the shareholder wealth focus is seemingly needed to attract interna-tional capital from outside investors, many of whom are from other countries. Second,and still quite controversial, many analysts believe that shareholder-based MNEs areincreasingly dominating their global industry segments. Nothing attracts followers likesuccess.

OPERATIONAL GOALS FOR MNES

Whether an MNE is trying to maximize shareholder or corporate wealth, it must beguided by operational goals suitable for various levels of the firm. Even if the firm’sgoal is to maximize shareholder value, the manner in which investors value the firm isnot always obvious to the firm’s top management. Many top executives believe that thestock market moves in mysterious ways and is not always consistent in its conclusions.

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Therefore, most firms hope to receive a favorable investor response to the achieve-ment of operational goals that can be controlled by the way in which the firm performs.

Because the MNE is a collection of many business units operating in a multitudeof economic environments, each MNE must determine for itself the proper balancebetween two common operational financial objectives:

1. Maximization of consolidated after-tax income and, subsequently, the minimiza-tion of the firm’s effective global tax burden

2. Correct positioning of the firm’s income, cash flows, and available funds as tocountry and currency

These goals are frequently incompatible, in that the pursuit of one may result in aless desirable outcome in regard to another. Management must make decisions aboutthe proper tradeoffs between goals about the future — which is why people rather thancomputers are employed as managers.

The primary operational goal of the MNE is to maximize consolidated profits,after-tax. Consolidated profits are the profits of all the individual units of the firm orig-inating in many different currencies expressed in the currency of the parent company.This is not to say that management is not striving to maximize the present value of allfuture cash flows. It is simply the case that most of the day-to-day decision-making inglobal management is about current earnings.The leaders of the MNE, the senior man-agement team who are developing and implementing the firm’s strategy, must think farbeyond current earnings.

For example, Trident’s foreign subsidiaries have their own set of traditional finan-cial statements: (1) a statement of income, summarizing the revenues and expensesexperienced by the firm over the year; (2) a balance sheet, summarizing the assetsemployed in generating the unit’s revenues and the financing of those assets; and (3) astatement of cash flows, summarizing those activities of the firm that generate and thenuse cash flows over the year. These financial statements are expressed initially in thelocal currency of the unit for tax and reporting purposes to the local government, butmust be consolidated with the parent company’s financial statements for reporting toshareholders.

Corporate Governance

The relationship among stakeholders used to determine and control the strategic direc-tion and performance of an organization is termed corporate governance.The corporategovernance of the organization is therefore the way in which order and process is estab-lished to ensure that decisions are made and interests are represented — for allstakeholders — properly.

Although the governance structure of any company, domestic, international, ormultinational, is fundamental to its very existence, this subject has become the light-ning rod of political and business debate in the past few years as failures in governancein a variety of forms have led to corporate fraud and failure.Abuses and failures in cor-porate governance have dominated global business news in recent years. Beginningwith the accounting fraud and questionable ethics of business conduct at Enron cul-minating in its bankruptcy in the fall of 2001, to the retirement pay package of RichardGrasso, the Chairman of the New York Stock Exchange, in September 2003, failures incorporate governance have raised issues about the very ethics and culture of the con-duct of business.

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2This definition of the corporate objective is based on that supported by the International CorporateGovernance Network (ICGN), a nonprofit organization committed to improving corporate governancepractices globally.

3“Principles of Corporate Governance,” OECD, 1999. Used with permission.

THE GOAL OF CORPORATE GOVERNANCE

The single overriding objective of corporate governance in the shareholder wealthmodel is the optimization over time of the returns to shareholders. In order to achievethis, good governance practices should focus the attention of the board of directors ofthe corporation on this objective by developing and implementing a strategy for thecorporation which ensures corporate growth and improvement in the value of the cor-poration’s equity. At the same time, it should assure an effective relationship withstakeholders.2

The most widely accepted statement of good corporate governance practices arethose established by the Organisation for Economic Cooperation and Development(OECD) in 1999:3

• The rights of shareholders. The corporate governance framework should protectshareholders’ rights.

• The equitable treatment of shareholders. The corporate governance frameworkshould ensure the equitable treatment of all shareholders, including minority andforeign shareholders. All shareholders should have the opportunity to obtaineffective redress for violation of their rights.

• The role of stakeholders in corporate governance. The corporate governanceframework should recognize the rights of stakeholders as established by law andencourage active cooperation between corporations and stakeholders in creatingwealth, jobs, and the sustainability of financially sound enterprises.

• Disclosure and transparency. The corporate governance framework should ensurethat timely and accurate disclosure is made on all material matters regarding thecorporation, including the financial situation, performance, ownership, and gover-nance of the company.

• The responsibilities of the board. The corporate governance framework shouldensure the strategic guidance of the company, the effective monitoring of man-agement by the board, and the board’s accountability to the company and theshareholders.

These principles obviously focus on several key areas — shareholder rights and roles,disclosure and transparency, and the responsibilities of boards — which we will discussin more detail below.

THE STRUCTURE OF CORPORATE GOVERNANCE

Our first challenge is to try and capture what people mean when they use the expres-sion “corporate governance.” Exhibit 1.8 provides an overview of the various partiesand their associated responsibilities associated with the governance of the modern cor-poration. The modern corporation is a complex organism living in a complex environ-ment. Its actions and behaviors are directed and controlled by both internal forces andexternal forces.

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Equity MarketsAnalysts and other market agents

evaluate the performance ofthe firm on a daily basis

Board of DirectorsChairman of the board andmembers are accountable

for the organization

Corporate governance represents the relationshipamong stakeholders that is used to determine andcontrol the strategic direction and performanceof the organization.

ManagementChief executive officer(CEO) and team run

the company

Debt MarketsRatings agencies and other

analysts review the ability ofthe firm to service debt

AuditorsProvide an external opinion

as to the fairness of presentationand conformity to standards of

financial statements

RegulatorsSEC, the NYSE, or other

regulatory bodies by country

The Corporation (internal)

The Marketplace (external)

EXHIBIT 1.8The Structure of

CorporateGovernance

The internal forces, the officers of the corporation (such as the chief executive offi-cer or CEO) and the board of directors of the corporation (including the chairman ofthe board), are those directly responsible for determining both the strategic directionand the execution of the company’s future. But they are not acting within a vacuum;they are subject to the constant prying eyes of the external forces in the marketplacewho question the validity and soundness of their decisions and performance. Theseinclude the equity markets in which the shares are traded, the analysts who critiquetheir investment prospects, the creditors and credit agencies who lend them money,the auditors who testify to the fairness of their reporting, and the multitude of regula-tors who oversee their actions in order to protect the investment public.

THE BOARD OF DIRECTORS. The legal body which is accountable for the gover-nance of the corporation is its board of directors. The board is composed of bothemployees of the organization (inside members) and senior and influential nonem-ployees (outside members).Areas of debate surrounding boards include the following:(1) the proper balance between inside and outside members; (2) the means by whichboard members are compensated for their service; and (3) the actual ability of a boardto adequately monitor and manage a corporation when board members are spendingsometimes less than five days a year on board activities. Outside members, very oftenthe current or retired chief executives of other major companies, may bring with thema healthy sense of distance and impartiality, which although refreshing, may also resultin limited understanding of the true issues and events within the company.

OFFICERS AND MANAGEMENT. The senior officers of the corporation — the chiefexecutive officer (CEO), the chief financial officer (CFO), and the chief operating officer(COO) — are not only the most knowledgeable of the business, but the creators and

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directors of its strategic and operational direction.The management of the firm is, accord-ing to theory, acting as a contractor — as an agent — of shareholders to pursue value creation. They are motivated by salary, bonuses, and stock options (positively) or the riskof losing their jobs (negatively). They may, however, have biases of self-enrichment or personal agendas which the board and other corporate stakeholders are responsible foroverseeing and policing. Interestingly enough, in more than 80% of the companies in theFortune 500, the CEO is also the chairman of the board. This is, in the opinion of many, aconflict of interest and not in the best interests of the company and its shareholders.

EQUITY MARKETS. The publicly traded company, regardless of country of resi-dence, is highly susceptible to the changing opinion of the marketplace. The equitymarkets themselves, whether they be the New York Stock Exchange, London StockExchange, or Mexico City Bolsa, should reflect the market’s constant reflections on thepromise and performance of the individual company. The analysts are those self-described experts employed by the many investment banking firms who also trade inthe client company shares. They are expected (sometimes naively) to evaluate thestrategies, plans for execution of the strategies, and financial performance of the firmson a real-time basis. Analysts depend on the financial statements and other public dis-closures of the firm for their information.

DEBT MARKETS. Although the debt markets (banks and other financial institutionsproviding loans and various forms of securitized debt like corporate bonds), are notspecifically interested in building shareholder value, they are indeed interested in thefinancial health of the company. Their interest, specifically, is in the company’s abilityto repay its debt in a timely and efficient manner. These markets, like the equity mar-kets, must rely on the financial statements and other disclosures (public and private inthis case) of the companies with which they work.

AUDITORS. Auditors are responsible for providing an external professional opinionas to the fairness and accuracy of corporate financial statements. In this process, theyattempt to determine whether the firm’s financial records and practices follow what inthe United States is termed generally accepted accounting principles (GAAP) in regardto accounting procedures. But auditors are hired by the firms they are auditing, lead-ing to a rather unique practice of policing their employers. The additional difficultywhich has arisen in recent years is that the major accounting firms pursued the devel-opment of large consulting practices, often leading to a conflict of interest. An auditornot giving a clean bill of health to a client could not expect to gain many lucrative con-sulting contracts from that same firm in the near future.

REGULATORS. Publicly traded firms in the United States and elsewhere are subjectto the regulatory oversight of both governmental organizations and nongovernmentalorganizations. In the United States the Securities and Exchange Commission (SEC) isa careful watchdog of the publicly traded equity markets, both in the behavior of thecompanies themselves in those markets and of the various investors participating inthose markets. The SEC and other authorities like it outside of the United Statesrequire a regular and orderly disclosure process of corporate performance in orderthat all investors may evaluate the company’s investment value with adequate, accu-rate, and fairly distributed information. This regulatory oversight is often focused onwhen and what information is released by the company, and to whom.

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Regime Basis Characteristics Examples

Market based Efficient equity markets; dispersed ownership United States, United Kingdom, Canada,

Australia

Family based Management and ownership is combined; family/ Hong Kong, Indonesia, Malaysia,

majority and minority shareholders Singapore, Taiwan, France

Bank based Government influence in bank lending; lack of Korea, Germany

transparency; family control

Government affiliated State ownership of enterprise; lack of China, Russia

transparency; no minority influence

Source: Based on “Corporate Governance in Emerging Markets: An Asian Perspective,” by J. Tsui and T. Shieh, in International Financeand Accounting Handbook, Third Edition, Frederick D. S. Choi, editor, Wiley, 2004, pp. 24.4–24.6.

EXHIBIT 1.9Comparative Corporate Governance Regimes

A publicly traded firm in the United States is also subject to the rules and regula-tions of the exchange on which they are traded (New York Stock Exchange, AmericanStock Exchange, and NASDAQ being the largest). These organizations, typically cate-gorized as “self-regulatory” in nature, construct and enforce standards of conduct forboth their member companies and themselves in share trading. Unfortunately, as therecent case of Richard Grasso and his retirement package of $148 million pointed out,it often appears that the “fox is in charge of the hen house.”

COMPARATIVE CORPORATE GOVERNANCE

The origins of the need for a corporate governance process arise from the separationof ownership from management, and from the varying views by culture of who thestakeholders are and of what significance.This assures that corporate governance prac-tices will differ across countries, economies, and cultures. As described in Exhibit 1.9,though, the various corporate governance regimes may be classified by regime. Theregimes in turn reflect the evolution of business ownership and direction within thecountries over time.

Market-based regimes, like those of the United States and the United Kingdom,are characterized by relatively efficient capital markets in which the ownership of pub-licly traded companies is widely dispersed. Family-based systems, like those character-ized in many of the emerging markets,Asian markets, and Latin American markets, notonly started with strong concentrations of family ownership (as opposed to partner-ships or small investment groups which are not family based), but have continued tobe largely controlled by families even after going public. Bank-based and government-based regimes are those reflecting markets in which government ownership of propertyand industry has been the constant force over time, resulting in only marginal “publicownership” of enterprise, and even then, subject to significant restrictions on businesspractices.

These regimes are therefore a function of at least three major factors in the evo-lution of corporate governance principles and practices globally: (1) financial marketdevelopment, (2) the degree of separation between management and ownership, and(3) the concept of disclosure and transparency.

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4Mara Faccio and Larry H. P. Lang, “The Ultimate Ownership of Western European Corporations,”Journal of Financial Economics, 65 (2002), p. 365. See also: Torben Pedersen and Steen Thomsen,“European Patterns of Corporate Ownership,” Journal of International Business Studies, Vol. 28, No. 4,Fourth Quarter, 1997, pp. 759–778.

5Ronald C. Anderson and David M. Reeb, “Founding Family Ownership and Firm Performance from theS&P500,” The Journal of Finance, June 2003, p. 1301.

FINANCIAL MARKET DEVELOPMENT. The depth and breadth of capital markets iscritical to the evolution of corporate governance practices. Country markets whichhave had relatively slow growth, as in the emerging markets, or have industrialized rap-idly utilizing neighboring capital markets (as is the case of Western Europe), may notform large public equity market systems. Without significant public trading of owner-ship shares, high concentrations of ownership are preserved and few disciplinedprocesses of governance developed.

SEPARATION OF MANAGEMENT AND OWNERSHIP. In countries and cultures inwhich the ownership of the firm has continued to be an integral part of management,agency issues and failures have been less a problem. In countries like the United States,in which ownership has become largely separated from management (and widely dis-persed), aligning the goals of management and ownership is much more difficult.

DISCLOSURE AND TRANSPARENCY. The extent of disclosure regarding the opera-tions and financial results of a company vary dramatically across countries. Disclosurepractices reflect a wide range of cultural and social forces, including the degree of own-ership which is public, the degree to which government feels the need to protectinvestor’s rights versus ownership rights, and the extent to which family-based and government-based business remains central to the culture. Transparency, a parallelconcept to disclosure, reflects the visibility of decision-making processes within thebusiness organization.

Note that the word ethics has not been used. All of the principles and practicesdescribed so far have assumed that the individuals in roles of responsibility and lead-ership pursue them truly and fairly. That, however, has not always been the case.

FAMILY OWNERSHIP AND CORPORATE GOVERNANCE

Although much of the discussion about corporate governance concentrates on the market-based regimes (Exhibit 1.9), family-based regimes are arguably more common andmore important worldwide, including in the United States and Western Europe. For exam-ple, in a study of 5,232 corporations in 13 Western European countries, family-controlledfirms represented 44.29% of the sample, compared to 36.93% that were widely held.4

Recent research indicates that, as opposed to popular belief, family-owned firms insome highly developed economies typically outperform publicly owned firms. This istrue not only in Western Europe but also in the United States. A recent study of firmsincluded in the S&P500 found that families are present in fully one third of the S&P500and account for 18% of their outstanding equity. And, as opposed to popular opinion,family firms outperform nonfamily firms. (An added insight is that firms possessing aCEO from the family also perform better than those with outside CEOs.) Interestingly,it seems that minority shareholders are actually better off according to this study whenpart of a family-influenced firm.5

Another study based on 120 Norwegian, founding-family controlled and non-founding family controlled firms, concluded that founding-family control was associ-ated with higher firm value. Furthermore, the impact of founding-family directors on

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6Chandra S. Mishra, Trond Randøy, and Jan Inge Jenssen, “The Effect of Founding Family Influence onFirm Value and Corporate Governance,” Journal of International Financial Management and Accounting,Vol. 12, No. 3, Autumn 2001, pp. 235–259.

firm value is not affected by corporate governance conditions such as firm age, boardindependence, and number of share classes. The authors also found that the relation-ship between founding-family ownership and firm value is greater among older firms,firms with larger boards, and particularly when these firms have multiple classes ofstock.6 It is common for Norwegian firms and firms based in several other Europeancountries to have dual classes of stock with differential voting rights.

FAILURES IN CORPORATE GOVERNANCE

Failures in corporate governance have become increasingly visible in recent years. TheEnron scandal in the United States is described in the mini-case at the end of this chap-ter. In addition to Enron, other U.S. firms that have revealed major accounting and dis-closure failures, as well as executives looting the firm, are WorldCom, Global Crossing,Tyco, Adelphia, and HealthSouth.

In each case, prestigious auditing firms, such as Arthur Andersen, missed the vio-lations or minimized them presumably because of lucrative consulting relationships orother conflicts of interest. Moreover, security analysts urged investors to buy the sharesof these and other firms that they knew to be highly risky or even close to bankruptcy.Even more egregious, most of the top executives that were responsible for the mis-management that destroyed their firms, walked away with huge gains on shares soldbefore the downfall, and even overly generous severance payments.

It appears that the day of reckoning has come.The first to fall was Arthur Andersen,for its involvement with Enron. However, many more legal actions against formerexecutives are underway. Some of these are described in Real World Example 1.1.

Real World Example 1.1CORPORATE CRIME: THE RECKONING

The federal indictment of Bernard J. Ebbers,the former CEO and chairman of WorldCom, isbut the latest in a long list of actions taken inreaction to the wave of corporate fraud and finan-cial finagling that accompanied America’s greatboom and bust. To those cynics who predictedthat nothing much would be done to reform BigBusiness and Wall Street, just look at the record.

New York Attorney General Eliot Spitzernegotiated settlements that reduce conflicts ofinterest among stock analysts, clean up the initialpublic offering market, provide independentresearch to investors, and punish investmentbanks for past sins. He is now taking the mutual-fund industry to task for late trading. Congresspassed Sarbanes-Oxley legislation that reformsboth accounting and corporate governance whilethe Financial Accounting Standards Board isabout to implement new rules requiring compa-nies to expense stock options.

Meanwhile, the list of corporate chieftainscharged with illegal acts grows. WorldCom’s Scott

D. Sullivan pleaded guilty, Enron Corp. Ex-ChiefFinancial Officer Andrew S. Fastow pleadedguilty, and former CEO Jeffrey K. Skilling is underindictment. Only former Chairman Kenneth L. Layremains untouched. Tyco International Ltd.’sMark Schwartz and L. Dennis Kozlowski are ontrial. HealthSouth Corp.’s Richard M. Scrushy isabout to go on trial. Adelphia CommunicationsCorp. founder John Rigas and his two sons are ontrial.

America has many strengths, but none is asimportant as its ability to quickly repair itself.After a series of business and financial scandalsunprecedented in modern times, the system isnow fairer and more transparent. The quality ofearnings is higher, boards are more independent,and investors have renewed confidence. Thanksto reform, the foundation for a strong rebound inthe economy in the months ahead has been laid.

Source: “Corporate Crime: The Reckoning,” Business Week,March 15, 2004, p. 128. © 2004 The McGraw-Hill Companies. AllRights Reserved.

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Real World Example 1.2WHEN SCANDALS GO GLOBAL

The cockroach theory of financial scandalssays that, for every one you see, hundreds moreare hiding in the woodwork. So it was in the U.S.,when the scandal at Enron was followed byblowups at WorldCom, HealthSouth, and else-where. And so it is now abroad; first Dutch gro-cer Ahold, then Italian dairy-products companyParmalat, and now Hollinger International Inc.,the newspaper company controlled by Conrad M.Black, a Canadian-born British lord.

Scandals break out in bunches because theyhave common causes. They occur when insiderstake advantage of weak corporate governance,feeble government oversight, and a financial sys-tem that too often looks the other way.

Indeed, Parmalat’s failure reflects badly onwhat were some of the biggest names in interna-tional finance in the ‘90’s. Bank of America, ChaseManhattan, Bank of Boston, Deutsche Bank,Barclays, and Merrill Lynch sold billions of dollarsin Parmalat debt over the years. While there’s noevidence that the financial giants broke rules, a lit-tle skeptical probing would have revealed the rotat the heart of Parmalat years ago.

The slow-motion fall of Conrad Black appearsto be a case of high-handedness and question-able governance. The press baron is denying alle-gations in a lawsuit that he arranged payments tohimself and others that weren’t properly author-ized by the board of directors. If the board letBlack run Hollinger for his own benefit, it reflectsbadly on luminary directors such as Henry A.Kissinger and Richard N. Perle.

There is obvious harm to these companies’shareholders and creditors, such as Parmalatbondholder AFLAC Inc. Less visible but more seri-ous is the destruction of trust, which makes itharder for honest companies to raise the moneythey need to grow. Overseas, as in the U.S., thesolutions are clear: Transparency. Accountability.Tough audits. And criminal penalties for thosewho cheat. Halfway measures are an invitation tomore cheating.

Source: “When Scandals Go Global,” Business Week,February 2, 2004, p. 96.

Although the corruption scandals were first revealed in the United States, theyhave spread to Canada and the European Union countries. These scandals aredescribed in Real World Example 1.2.

GOOD GOVERNANCE AND REPUTATION

Does good governance matter? This is actually a difficult question, and the realisticanswer has been largely dependent on outcomes historically. For example, as long asEnron’s share price continued to rise dramatically throughout the 1990s, questionsover transparency, accounting propriety, and even financial facts were largely over-looked by all of the stakeholders of the corporation. Yet, eventually, the fraud anddeceit and failure of the multitude of corporate governance practices resulted in thebankruptcy of the firm, destroying not only the wealth of investors, but the careers,incomes, and savings of so many of its basic stakeholders — its own employees.Ultimately, yes, good governance does matter. A lot.

A second way of valuing good governance is by measuring the attitudes and ten-dencies of the large global institutional investors who make the largest decisions aboutwhere capital may go. A recent McKinsey study surveyed over 200 institutionalinvestors as to the value they placed on good governance.The survey results, presentedin Exhibit 1.10, quantify good governance as the premium that institutional investorswould be willing to pay for companies with good governance within specific countrymarkets.Although this is not exactly equivalent to saying who has “good” or “bad” cor-porate governance globally, it does provide some insight as to in which countries insti-tutional investors see good governance as scarce. It is again important to note that

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How much more (what premium) would you be willing to pay for a share in a ‘good governance’ company inthe following countries?

Source: “McKinsey Global Investor Opinion Survey on Corporate Governance, 2002,” McKinsey & Company, July 2002.

Mor

occo

40%

35%

30%

25%

20%

15%

10%

5%

0

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tRu

ssia

Turke

yInd

ones

iaCh

inaAr

gent

inaVe

nezu

elaBr

azil

Polan

dInd

iaM

alays

iaPh

ilippin

esSo

uth A

frica

Japa

nSin

gapo

reCo

lumbia

Sout

h Kor

eaTh

ailan

dM

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Taiw

anCh

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lySw

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land

U.S.

Spain

German

yFra

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Swed

en U.K.

Cana

da

EXHIBIT 1.10The Value of Good

Governance

most of the emerging market nations have relatively few publicly traded companieseven today.

This is not a surprise to the “sell-side” — the companies themselves. Corporateleadership globally is increasingly concerned with the nature of its reputation, andcorporate governance failures are high on the list of issues that impact corporatereputation.

CORPORATE GOVERNANCE REFORM

The debate regarding what needs to be done about corporate governance reformdepends on which systems and regimes are deemed superior. To date, reform in theUnited States has been largely regulatory.

SARBANES-OXLEY ACT. The U.S. Congress passed the Sarbanes-Oxley Act in July2002. It had three major requirements: (1) CEOs of publicly traded firms must vouchfor the veracity of the firm’s published financial statements; (2) corporate boards musthave audit committees drawn from independent (outside) directors; and (3) companiesare prohibited from making loans to corporate officers and directors. The first provi-sion — the so-called signature clause — has already had significant impacts on the wayin which companies prepare their financial statements. Although the provision wasintended to instill a sense of responsibility and accountability in senior management(and therefore fewer explanations of “the auditors signed off on it”), the companiesthemselves have pushed the same procedure downward in their organizations, often

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EXHIBIT 1.11Board Composition and Compensation, Fortune 100


Size of Company (sales) Total Directors Outside Directors Avg. Annual Retainer

Less than $3 billion 9 7 $33,792

$3–$4.9 billion 10 8 $37,567

$5–$9.9 billion 12 10 $42,264

$10–$19.9 billion 12 10 $47,589

$20 billion and over 13 11 $6,587

Source: Korn/Ferry International, as quoted in “The Way We Govern Now,” The Economist, January 9, 2003 (print edition).

requiring business unit managers and directors at lower levels to sign their financialstatements.

Sarbanes-Oxley has been quite controversial internationally, as it is in conflict witha number of the existing corporate governance practices already in place in marketsthat view themselves as having better governance records than the United States. Aforeign firm wishing to list or continue listing their shares on a U.S. exchange mustcomply with the law. Some companies, such as Porsche, withdrew plans for a U.S. list-ing specifically in opposition to Sarbanes-Oxley. Other companies, however, includingmany of the largest foreign companies traded on U.S. exchanges such as Unilever,Siemens, and ST Microelectronics, have stated their willingness to comply — if theycan find acceptable compromises between U.S. law and the governance requirementsand principles in their own countries. For example, in Germany, supervisory boardaudit committees must include employee representatives, but according to U.S. law,employees are not independent.

BOARD STRUCTURE AND COMPENSATION. Many critics have argued for theUnited States to move toward structural reforms more consistent with European stan-dards, such as prohibiting CEOs from also being chairmen. Although this is increas-ingly common, there is no regulatory or other legal requirement to force the issue.Second, and more radically, would be to move toward the two-tiered structure of coun-tries like Germany, in which there is a supervisory board (largely outsiders, and typi-cally large — Siemens’ board has 18 members) and a management board(predominantly insiders, and smaller — Siemens’ has eight members).As illustrated byExhibit 1.11, it is not clear that the director composition of boards is truly the problem.

Also under considerable debate is the amount and form of board compensation.In the past, the United States was characterized by boards in which compensation wasa combination of an annual stipend and the award of significant stock options. Thestock option incentive, although intended to align the goals and objectives of boardsand executive directors with the interests of shareholders, seemingly resulted in amind-set more akin to the gift of lotto tickets — encouraging aggressive growth andaccounting in the interest of earnings growth and share price appreciation.

TRANSPARENCY, ACCOUNTING, AND AUDITING. The concept of transparency hasbeen raised in a variety of markets and contexts. Transparency is a rather commonterm used to describe the degree to which an investor — either existing or potential —

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Real World Example 1.3CONRAD BLACK AND MINORITY SHAREHOLDER RIGHTS

Conrad Black was CEO of Hollinger Inter-national, a Canadian corporation listed on theNew York Stock Exchange. Black controlled thecompany via a complex management agreementand through a holding company which held amajority of Hollinger’s voting shares. He wasknown to have little patience for shareholderquestions, particularly when they were about howhe was managing the firm. In a 2003 stockholder

meeting he responded to continued questionswith the following: “You have a right to say what-ever it is that is on your mind, all of you,” heinformed his investors. “You don’t know what youare talking about, but you are still welcome asshareholders.” He resigned as chairman and CEOin November 2003, under pressure.

Source: Adapted from “Hollinger Black & Blue,” DavidLeonard, Fortune, September 29, 2003.

can discern the true activities and value drivers of a company from the disclosures andfinancial results reported. For example, Enron was often considered a “black box”when it came to what the actual operational and financial results and risks were for itsmultitude of business lines. The consensus of corporate governance experts is that allfirms, globally, should work toward increasing the transparency of the firm’s risk-return profile.

The accounting process itself has now come under debate. The U.S. system is char-acterized as strictly rule-based, rather than conceptually based, as is common inWestern Europe. Many critics of U.S. corporate governance practices point to this as afundamental flaw, in which constantly more clever accountants find ways to follow therules, yet not meet the underlying purpose for which the rules were intended. Anextension of the accounting process debate is that of the role and remuneration asso-ciated with auditing, the process of using third parties, paid by the firm, to vet theirreporting practices as being consistent with generally accepted accounting principles.As illustrated by the collapse of Arthur Andersen following the Enron debacle, thereare serious questions as to how much faith investors can place in the results of this cur-rent practice.

MINORITY SHAREHOLDER RIGHTS. Finally, the issue of minority shareholderrights continues to rage in many of the world’s largest markets. Many of the emergingmarkets are still characterized by the family-based corporate governance regime,where the family remains in control even after the firm has gone public. But what ofthe interests and voices of the other shareholders? How are their interests preservedin organizations where families or private investors control all true decisions, includingthe boards? As Real World Example 1.3 on Conrad Black of Hollinger Internationalpoints out, minority shareholder rights are threatened in all markets, industrialized oremerging.

Poor performance of management usually requires changes to management, own-ership, or both. Exhibit 1.12 illustrates some of the alternative paths available to share-holders when dissatisfied with firm performance.

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M I N I - C A S E

The Failure of Corporate Governance at Enron“The tragic consequences of the related-party trans-actions and accounting errors were the result of fail-ures at many levels and by many people: a flawedidea, self-enrichment by employees, inadequately-designed controls, poor implementation, inattentiveoversight, simple (and not-so-simple) accounting mis-takes, and overreaching in a culture that appears tohave encouraged pushing the limits. Our review indi-cates that many of those consequences could andshould have been avoided.”

“Report of Investigation by the Special InvestigativeCommittee of the Board of Directors of Enron

Corporation,” Board of Directors, Enron, February 1, 2002, pp. 27–28.

On December 2, 2001, Enron Corporation filed forbankruptcy protection under Chapter 11. Enron failed as aresult of a complex combination of business and gover-nance failures. As noted in the quotation from the boardreport reprinted above, the failures involved organizationsand individuals both inside and outside of Enron. But out-side of the courts and sensational press, the questionremains as to how the system allowed it to happen. Whydid the many structures and safeguards within the U.S.corporate governance system not catch, stop, or preventthe failure of Enron?

Enron’s CollapseAccording to former Enron CEO Jeffrey Skilling, Enronfailed because of a “run on the bank.” This in fact, is prob-ably technically correct. When Enron’s credit rating wasdowngraded to below investment grade in November 2001by the credit rating agencies, its business was effectivelystopped. This was because as a trading company it neededto maintain an investment-grade rating in order for othercompanies to trade with it. No grade, no trade.

But that answer largely begs the question of why thecompany was downgraded — because Enron’s total indebt-edness was now determined to be $38 billion, not $13 bil-lion. Why was the debt now, suddenly, so high? Becausemuch of the debt that had been classified as off-balancesheet was now reclassified to on-balance sheet. Why thereclassification? Because many of the special-purpose enti-ties (SPEs) and off-balance sheet partnerships carrying thisdebt were either found to have been misclassified to beginwith or were reconsolidated with the company as a resultof their equity falling in value (Enron shares). Which leadsus back to the beginning — why did Enron’s share pricetumble in 2001? Was it simply a natural result of a failingbusiness, or had Enron’s reported and prospective earn-ings, in combination with its general financial health, notbeen honestly reported and evaluated?

Popular Term

The Past

Walk-Away

Shareholder Activism

Maximum Threat

What counts is that the management of a publicly quoted company, and its board of directors,know that the company can become the subject of a hostile takeover bid if they fail to perform.

Remain Quietly Disgruntled

Sell the Shares

Change Management

Initiate a Takeover

ShareholderDissatisfaction

Possible Action

EXHIBIT 1.12Potential

Responses toShareholder

Dissatisfaction

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Failure of Corporate Governance at EnronEnron’s senior management team, primarily the CEOKenneth Lay and COO Jeffrey Skilling (later CEO) wereresponsible for the formulation and implementation of thecompany’s strategy, including its operating and financialresults. Like most companies of its size, Enron had literallyhundreds of accountants and lawyers on its permanentstaff. It was the concerns of one accountant, SherronWatkins, which became public in August and September2001 and contributed to the rapidly escalating examinationof Enron and its operations in the fall of 2001.

In the case of Enron, the external corporate governancebodies have been the focus of much criticism.

• Auditor. Arthur Andersen (one of the so-called Big Five)was Enron’s auditor. Andersen’s job was to determineand annually testify as to whether Enron had followedgenerally accepted accounting practices in the state-ments of its financial results. Andersen, like all auditors,was hired and paid by the company it was auditing:Enron. Andersen also provided a large variety of con-sulting activities for Enron, the sum of which was a muchlarger line of business than the basic audit practice.

• Legal counsel. Enron’s legal counsel, primarily the firmof Vinson & Elkins of Houston, was responsible for pro-viding legal opinions on the many strategies, structures,and general legality of much of what Enron did. As wasthe case with Arthur Andersen, when questioned lateras to why it did not oppose certain ideas or practices,Vinson & Elkins explained that it had not been fullyinformed of all of the details and complexities of themanagement and ownership of the SPEs.

• Regulators. Enron actually fell between the cracks ofmost U.S. regulatory bodies by industry. Because Enronwas a trader in the energy markets, the Federal EnergyRegulatory Commission (FERC) had some distant over-sight responsibilities in regard to some of the marketsand trading which the company participated in, but werelargely separate issues from Enron’s overall activities.

• Equity markets. As a publicly traded company, Enronwas subject to the rules and regulations of the Securitiesand Exchange Commission (SEC). The SEC, however,does little firsthand investigation or confirmation ofreporting diligence itself, relying instead on the testimo-nials of other bodies like the company’s auditor.

Because its shares were traded on the New YorkStock Exchange (NYSE), Enron was governed by therules and regulations of that exchange. At this time,however, the reporting requirements of the NYSE dif-fered little if at all from those of the SEC. The NYSE didno firsthand verification of compliance on its own.

Analysts for a multitude of investment banking firmswere responsible for following, analyzing, and evaluatingEnron’s results on a constant basis. Enron’s relation-

ships with its investment bankers frequently involvedquid pro quo behavior, in which firms that cooperatedwith Enron and supported its performance stories wererewarded with new business and new mandates forother investment banking activities that were profitableto the firms.

• Debt markets. Enron, like all companies who desiredand needed a credit rating, paid companies likeStandard & Poor’s and Moody’s to provide it with acredit rating. These ratings are needed for the com-pany’s debt securities to be issued and traded in themarketplace. Again, one of the problems which thecredit ratings agencies had with Enron was that theycould only provide analysis on what was known to themof Enron’s operational and financial activities andresults. And, in the case of debt knowingly held by off-balance sheet special-purposes entities, there is consid-erable debate as to whether the credit rating agencieshad full detail and knowingly chose to overlook them inthe company’s total indebtedness or not.

And finally let’s not forget the banks and bankers them-selves, who provided the access to the debt capital. Most ofthese banks made millions in interest and fees as a result ofleading and managing debt issuances for Enron.

Feeding the BeastA particularly troublesome feature of Enron’s emergingbusiness model in the late 1990s was that revenues grewmuch faster than earnings. The cost of undertaking largeinternational power projects (such as in India), electricalpower trading, and even new trading ventures such as thetrading in water rights and broadband, were, in the wordsof one former executive, “hideous.” The salaries, bonuses,startup costs, and general lack of control over all operatingcosts drowned whatever profits arose from the new ven-tures. Even the more successful trading lines, includingelectricity, did not generate the margins the marketplacehad come to expect from Enron and its older portfolio ofbusinesses (primarily natural gas trading). As illustrated inExhibit 1, the actual operating income (income before inter-est and taxes or IBIT) by business line was not growing atthe same pace as revenues.

The growing deficit in corporate cash flows also led to amore fundamental financial management problem forEnron, the growing need for external capital, or as it wasdescribed in-house, “feeding the beast.” Rapidly escalatinginvestments in new businesses, whether they be thePortland General Electric (PGE) acquisition of 1997 or thepower projects pursued by Rebecca Mark (the director ofEnron’s international development group) globally, wereabsorbing more capital than current business could self-finance. Enron’s cash flows fell increasingly behind itsinvestments and sales.

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7“Report of Investigation: Special Investigative Committee ofthe Board of Directors of Enron Corporation,” Board ofDirectors, Enron, February 1, 2002 (often called The PowersReport), p. 5.

Enron needed additional external capital — new debtand new equity. Ken Lay and Jeff Skilling, however, wereboth reluctant to issue large amounts of new equitybecause it would dilute earnings and the holdings of exist-ing shareholders. The debt option was also limited, giventhe already high debt levels Enron was carrying (and whichit had carried since its inception) which left it in the contin-uously precarious position of being rated BBB, just barelyinvestment grade, by credit agency standards.

Although Jeff Skilling had first employed the concept of afund of capital to be created to support business developmentwithin Enron with the creation of the Cactus Fund in 1991, itwas Andrew Fastow who took the concept to a whole newlevel. Fastow’s experience in banking, specifically in the use ofspecial-purpose entities (SPEs), a common tool in financialservices, was his ticket up the corporate ladder at Enron. Heeventually rose to the CFO position.

Many of the transactions involve an accounting struc-ture known as a “special purpose entity” or “specialpurpose vehicle” (referred to as an “SPE” in thisSummary and in the Report). A company that doesbusiness with an SPE may treat that SPE as if it werean independent, outside entity for accounting purposesif two conditions are met: (1) an owner independent ofthe company must make a substantive equity invest-ment of at least 3% of the SPE’s assets, and that 3%must remain at risk throughout the transaction; and (2)the independent owner must exercise control of theSPE. In those circumstances, the company may record

gains and losses on transactions with the SPE, and theassets and liabilities of the SPE are not included in thecompany’s balance sheet, even though the companyand the SPE are closely related. It was the technicalfailure of some of the structures with which Enron didbusiness to satisfy these requirements that led toEnron’s restatement.7

The SPEs created by Andy Fastow and his assistantMichael Kopper served two very important purposes. First, byselling troubled assets to the partnerships, Enron removedthem from its balance sheet, taking pressure off the firm’stotal indebtedness and simultaneously hiding underperform-ing investments. This also freed up additional room on thebalance sheet to fund new investment opportunities.Secondly, the sale of the troubled investments to the partner-ships generated income which Enron could then use to makeits quarterly earnings commitments to Wall Street.

The problem with this solution was that it was only tem-porary. The SPEs were largely funded from three sources: (1)equity in the form of Enron shares by Enron; (2) equity in theform of a minimum 3% of assets by an unrelated third party(in principle, although this was later found to not be true in anumber of cases); and (3) large quantities of debt from majorbanks. This capital base made up the right-hand side of the

$2,500

$2,000

$1,500

$1,000

$500

0

–$500

Enro

n’s

Earn

ings

by

Segm

ent

(IBIT

*, m

illio

ns)

* IBIT is income before interest and taxes

1996 1997 1998 1999 2000

Transp and Dist Wholesale Energy Retail Energy Broadband E&P Other

EXHIBIT 1

CH01_p.001-034 1/14/05 3:08 PM


8Power Failure, by Sherron Watkins, p. 232. “Raptors” and“LJM2” refer to special-purpose entities.

SPE’s balance sheet. On the left-hand side, the capital wasused to purchase a variety of assets from Enron. Fastow soldthese partnership deals to the banks on the premise thatbecause he was uniquely positioned as both the CFO ofEnron and the managing partner in the SPE, he couldessentially cherry-pick the assets to be purchased by theSPE. Fastow did indeed cherry-pick, but they were the rot-ten cherries. Most of the assets purchased by the SPEswere troubled or underperforming.

A final detail of the SPEs proved in the end devastatingto the financial future of Enron. Since the primary equity inthe SPEs was Enron stock, as the share price rose through-out 1999 and 2000, the SPEs could periodically bemarked-to-market, resulting in an appreciation in the valueof the SPE and contributing significant earnings to Enron.These same shares, once their price began sliding in 2001,resulted in partnerships which should have been marked-to-market for substantial losses, but were not. As Enron’sshare price plummeted in the early fall of 2001, the equityin the SPEs would no longer meet accounting guidelines forremaining off-balance sheet. The SPEs were becomingsomething of a synthetic business for Enron.

“The trouble was, the Raptors, like the rest of LJM2,had become something of a dumping ground for badproperties. In an effort to make quarterly earnings(and, of course, annual bonuses), Enron originatorswere hooked on making deals with Fastow insteadof outside third parties — who would have asked alot of questions, slowed down the process, and, inmany cases, killed deals. Again, none of this mat-tered to most people at Enron, as long as the stockkept rising.”8

The Failure of PeopleAs it turns out, much of what Enron reported as earningswere not. Much of the debt raised by the company via thepartnerships which was not disclosed in corporate financialstatements should have been. Simultaneously to the over-reporting of profits and the underreporting of debt, werethe massive compensation packages and bonuses earnedby corporate officers. So how could this happen?

• It appears that the executive officers of the firm weresuccessful in manipulating the board of directors.Management had moved the company into a number ofnew markets in which the firm suffered substantial

losses, resulting in redoubled attempts on their part tosomehow generate the earnings needed to meet WallStreet’s unquenchable thirst for profitable growth.

• The board failed in its duties to protect shareholderinterests through lack of due diligence and most likely afaith in the competence and integrity of the company’ssenior officers. It is also notable that Enron’s legal advi-sors, some of whom reported to the board directly, alsofailed to provide leadership on a number of instances ofmalfeasance.

• Enron’s auditors, Arthur Andersen, committed seriouserrors in its judgments regarding accounting treatmentfor many Enron activities, including the SPE partner-ships. Andersen was reported to have had serious con-flicts of interest, earning $5 million in auditing fees fromEnron in 2001, but more than $50 million in consultingfees in the same year.

• Enron’s analysts were, in a few cases, blinded by thesheer euphoria over Enron’s successes in the mid to late1990s, or were working within investment banks thatwere earning substantial investment banking feesrelated to the complex partnerships. Although a fewanalysts continued to note that the company’s earningsseemed strangely large relative to the falling cash flowsreported, Enron’s management was generally successfulin arguing their point.

The rise and fall of Enron is a story that is far fromcomplete. It may be in the end, however, that the truemoral of the story is not in the failure of any specificprocess in place within the American system of corporategovernance, nor in the mistaken focus on fair valueaccounting, nor in the lack of diligence of the board’s ownaudit committee, but simply the failure of people in a widevariety of positions in a great many different organizationsto act reputably and responsibly.

Case Questions1. Which parts of the corporate governance system,

internal and external, do you believe failed Enron themost?

2. Describe how you think each of the individual stake-holders and components of the corporate governancesystem should have either prevented the problems atEnron or acted to resolve the problems before theyreached crisis proportions.

3. If all publicly traded firms in the United States are oper-ating within the same basic corporate governance sys-tem as Enron, why would some people believe this wasan isolated incident and not an example of many failuresto come?

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Summary of Learning Objectives

Consider how the globalization process moves a busi-ness from a purely domestic focus in its financial rela-tionships and composition to one truly global in scope

• Financial management is an integral part of afirm’s strategy.The main purpose of this book is toanalyze how a firm’s financial management tasksevolve as it pursues global strategic opportunitiesand new constraints unfold.

Learn what the implications of phase one of globaliza-tion — the international trade phase — are for the risksand returns of a business

• The evolution of firms from purely domestic tomultinational is called the globalization process. Afirm may first enter into international trade trans-actions, then international contractual arrange-ments such as sales offices and franchising, andultimately the acquisition of foreign subsidiaries. Itis at this final stage that it truly becomes a multi-national enterprise (MNE).

• This globalization process results in a firm becom-ing increasingly influenced by exchange ratemovements and other global political and eco-nomic forces in general.

Examine how the continuing globalization processextends from international trade to multinational oper-ations to global activities

• The decision whether or not to invest abroad isdriven by strategic motives, and may require theMNE to enter into global licensing agreements,joint ventures, cross-border acquisitions, or green-field investments.

Discover what three major corporate currency expo-sures arise from multinational business

• The three major currency exposures arising fromthe conduct of multinational business that impactall firms are transaction exposure, operatingexposure, and translation exposure.

See how globalization affects governance of the organ-ization and how it creates value for its stakeholders

• The definitions of return and risk are not univer-sally accepted. Indeed, they may be culturallydetermined norms that vary by country.

• In the Anglo-American markets, the shareholderwealth maximization model is the culturally-determined norm. In many non–Anglo-Americanmarkets, the corporate wealth maximizationmodel is the culturally determined norm. Distinctdifferences exist as to how these models treatreturn and risk. Additionally, these culturallydetermined norms are in process of evolutionwithin many countries.

• As MNEs become more dependent on global cap-ital markets for financing they may need to mod-ify their policies of corporate governance.A trendexists for firms resident in non–Anglo-Americanmarkets to move toward being more “stockholderfriendly.” Simultaneously, firms from the Anglo-American markets may be moving toward beingmore “stakeholder friendly.”

Investigate failures in global corporate governance

• The relationship among stakeholders used todetermine and control the strategic direction andperformance of an organization is termed corpo-rate governance.

• Dimensions of corporate governance includeagency theory; composition and control of boardsof directors; and cultural, historical, and institu-tional variables.

• Failures in corporate governance, especially in theUnited States, have recently been in the spotlightand have been given partial blame for the declinein value of the U.S. stock markets.

• Shareholders who are dissatisfied with their firm’sperformance typically have four choices: remainquietly disgruntled; sell their shares; change man-agement; or initiate a takeover.

• The recent failures in corporate governance in theUntied States have spawned a flurry of govern-ment and private initiatives to prevent the samekind of failures in the future.

• The United States has already reacted to the recentfailures in corporate governance by passing theSarbanes-Oxley Act of 2002. The Act specificallyasks the CEOs of firms to vouch for their financialstatements and to create audit committees fromindependent directors. The Act, however, is incon-sistent with the policies and practices employed in

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many other countries, and has been a point of con-tention for firms considering listing (or continuedlistings) in the United States.

• The coming decade may see a growing consensusof corporate leaders who see the objectives of thefirm to include the environmental and socialsoundness of the firm’s activities in addition to thepursuit of profit.

QUESTIONS

1. Trident’s globalization. After reading the chapter’sdescription of Trident’s globalization process, howwould you explain the distinctions betweeninternational, multinational, and global companies?

2. Trident, the MNE. At what point in the globaliza-tion process did Trident become a multinationalenterprise (MNE)?

3. Trident’s advantages. What are the main advan-tages that Trident gains by developing a multina-tional presence?

4. Trident’s phases. What are the main phases thatTrident passed through as it evolved into a trulyglobal firm? What are the advantages and disad-vantages of each?

5. Corporate goals: shareholder wealth maximiza-tion. Explain the assumptions and objectives ofthe shareholder wealth maximization model.

6. Corporate goals: corporate wealth maximization.Explain the assumptions and objectives of thecorporate wealth maximization model.

7. Corporate governance. Define the followingterms

a. Corporate governance

b. The market for corporate control

c. Agency theory

d. Stakeholder capitalism

8. Operational goals. What should be the primaryoperational goal of an MNE?

9. Knowledge assets. Knowledge assets are a firm’sintangible assets, the sources and uses of its intel-lectual talent — its competitive advantage. Whatare some of the most important knowledge assetsthat create shareholder value?

10. Labor unions. In Germany and Scandinavia, amongothers, labor unions have representation on boards

of directors or supervisory boards. How might suchunion representation be viewed under the share-holder wealth maximization model compared tothe corporate wealth maximization model?

11. Interlocking directorates. In an interlockingdirectorate, members of the board of directors ofone firm also sit on the board of directors of otherfirms. How would interlocking directorates beviewed by the shareholder wealth maximizationmodel compared to the corporate wealth maxi-mization model?

12. Leveraged buyouts. A leveraged buyout is afinancial strategy in which a group of investorsgain voting control of a firm and then liquidate itsassets in order to repay the loans used to purchasethe firm’s shares. How would leveraged buyoutsbe viewed by the shareholder wealth maximiza-tion model compared to the corporate wealthmaximization model?

13. High leverage. How would a high degree of lever-age (debt/assets) be viewed by the shareholderwealth maximization model compared to the cor-porate wealth maximization model?

14. Conglomerates. Conglomerates are firms thathave diversified into unrelated fields. How woulda policy of conglomeration be viewed by theshareholder wealth maximization model com-pared to the corporate wealth maximizationmodel?

15. Risk. How is risk defined in the shareholderwealth maximization model compared to the cor-porate wealth maximization model?

16. Stock options. How would stock options grantedto a firm’s management and employees be viewedby the shareholder wealth maximization modelcompared to the corporate wealth maximizationmodel?

17. Shareholder dissatisfaction. If shareholders aredissatisfied with their company, what alternativeactions can they take?

18. Dual classes of common stock. In many countriesit is common for a firm to have two or moreclasses of common stock with different votingrights. In the United States the norm is for a firmto have one class of common stock with one-share-one-vote. What are the advantages and dis-advantages of each system?

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19. Emerging markets corporate governance failures.It has been claimed that failures in corporate gov-ernance have hampered the growth and prof-itability of some prominent firms located inemerging markets. What are some typical causesof these failures in corporate governance?

20. Emerging markets corporate governanceimprovements. In recent years emerging marketMNEs have improved their corporate governancepolicies and become more shareholder-friendly.What do you think is driving this phenomenon?

PROBLEMS

Use the following formula for shareholder returns toanswer questions 1 through 3, where Pt is the shareprice at time t, and Dt is the dividend paid at time t.

1. Shareholder returns. If a share price rises from$16.00 to $18.00 over a one-year period, what wasthe rate of return to the shareholder if

a. The company paid no dividends?

b. The company paid a dividend of $1.00 per share?

2. Shareholder choices. Wilford Fong, a prominentinvestor, is evaluating investment alternatives. Ifhe believes an individual equity will rise in pricefrom $62 to $74 in the coming one-year period,and the share is expected to pay a dividend of$2.25 per share, and he expects at least a 12% rateof return on an investment of this type, should heinvest in this particular equity?

3. Microsoft’s dividend. In January 2003 Microsoftannounced that it would begin paying a dividendof $0.16 per share. Given the following shareprices for Microsoft stock in the recent past, howwould a constant dividend of $0.16 per share peryear have changed the company’s return to itsshareholders over this period?

Closing ClosingFirst Share First ShareTrading Day Price Trading Day Price

1998 (Jan 2) $131.13 2001 (Jan 2) $43.38

1999 (Jan 4) $141.00 2002 (Jan 2) $67.04

2000 (Jan 3) $116.56 2003 (Jan 2) $53.72

4. Dual classes of common stock (A). Dual classesof common stock are popular in a number of

Shareholder returnP P D

P2 1 2

1= − +

countries.Assume that Powlitz Manufacturing hasthe following capital structure at book value:

LocalCurrency

Powlitz Manufacturing (millions)

Long-term debt 200

Retained earnings 300

Paid-in common stock: 1 million A-shares 100

Paid-in common stock: 4 million B-shares 400

Total long-term capital 1,000

The A-shares each have 10 votes; the B-shares eachhave 1 vote per share.

a. What proportion of the total long-term capitalhas been raised by A-shares?

b. What proportion of voting rights is repre-sented by A-shares?

c. What proportion of the dividends should theA-shares receive?

5. Dual classes of common stock (B). Assuming allof the same debt and equity values for PowlitzManufacturing as in problem 4, with the soleexception that both A-shares and B-shares havethe same voting rights, 1 vote per share:

a. What proportion of the total long-term capitalhas been raised by A-shares?

b. What proportion of voting rights is repre-sented by A-shares?

c. What proportion of the dividends should theA-shares receive?

6. Price/earnings ratios and acquisitions. During the1960s many conglomerates were created by a firmenjoying a high price/earnings ratio (P/E). Theythen used their highly valued stock to acquire otherfirms that had lower P/E ratios, usually in unrelateddomestic industries. These conglomerates went outof fashion during the 1980s when they lost theirhigh P/E ratios, thus making it more difficult to findother firms with lower P/E ratios to acquire.

During the 1990s, the same acquisition strategywas possible for firms located in countries wherehigh P/E ratios were common compared to firmsin other countries where low P/E ratios were com-mon. Assume the following hypothetical firms inthe pharmaceutical industry.

*End-of-chapter problems that utilize spreadsheets areavailable online at www.aw-bc.com/moffett and areaccompanied by this icon.

*

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MarketValue

P/E Number per Total MarketRatio of Shares Share Earnings EPS Value

Pharm-Italy 20 10,000,000 $20 $10,000,000 $1.00 $200,000,000Pharm-USA 40 10,000,000 $40 $10,000,000 $1.00 $400,000,000

Pharm-USA wants to acquire Pharm-Italy. Itoffers 5,500,000 shares of Pharm-USA, with a cur-rent market value of $220,000,000 and a 10% pre-mium on Pharm-Italy’s shares, for all ofPharm-Italy’s shares.

a. How many shares would Pharm-USA have out-standing after the acquisition of Pharm-Italy?

b. What would be the consolidated earnings ofthe combined Pharm-USA and Pharm-Italy?

c. Assuming the market continues to capitalizePharm-USA’s earnings at a P/E ratio of 40,what would be the new market value forPharm-USA?

d. What is the new earnings per share of Pharm-USA?

e. What is the new market value of a share ofPharm-USA?

f. How much did Pharm-USA’s stock priceincrease?

g. Assume that the market takes a negative viewof the merger and lowers Pharm-USA’s P/Eratio to 30. What would be the new marketprice per share of stock? What would be itspercentage loss?

7. Corporate governance: Overstating earnings. Anumber of firms, especially in the United States,have had to lower their previously reported earn-ings due to accounting errors or fraud. Assumethat Pharm-USA (problem 6) had to lower itsearnings to $5,000,000 from the previouslyreported $10,000,000. What might be its new mar-ket value prior to the acquisition? Could it still dothe acquisition?

Trident Corporation

Problems 8 through 10 are based on the hypo-thetical MNE Trident Corporation. Trident is aU.S.–based multinational manufacturing firm,with wholly-owned subsidiaries in Brazil,Germany, and China, in addition to domesticoperations in the United States. Trident is tradedon the NASDAQ. Trident currently has 650,000shares outstanding.The basic operating character-istics of the various business units is as follows:

ChinaUSA Brazil Germany (renminbi,

(000s, local currency) (dollars, $) (real, R$) (euros, €) Rmb)Earnings before $4,500 R$6,250 €4,500 Rmb2,500tax (EBT)Corporate income 35% 25% 40% 30%tax rateAverage exchange R$3.50/$ €0.9260/$ Rmb8.50/$rate for period

8. Trident Corporation’s consolidated earnings.Trident must pay corporate income tax in eachcountry in which it currently has operations.

a. After deducting taxes in each country, what areTrident’s consolidated earnings and consoli-dated earnings per share in U.S. dollars?

b. What proportion of Trident’s consolidatedearnings arise from each individual country?

c. What proportion of Trident’s consolidatedearnings arise from outside the United States?

9. Trident’s EPS sensitivity to exchange rates.Assume a major political crisis wracks Brazil, firstaffecting the value of the Brazilian real and, sub-sequently, inducing an economic recession withinthe country.

a. What would be the impact on Trident’s consol-idated EPS if the Brazilian real were to fall toR$4.50/$, with all other earnings and exchangerates remaining the same?

b. What would be the impact on Trident’s consol-idated EPS if, in addition to the fall in the valueof the real to R$4.50/$, but earnings beforetaxes in Brazil fell as a result of the recession toR$5,800,000?

10. Trident’s earnings and global taxation. All MNEsattempt to minimize their global tax liabilities.Return to the original set of baseline assumptionsand answer the following questions regardingTrident’s global tax liabilities.

a. What is the total amount — in U.S. dollars —which Trident is paying across its global busi-ness in corporate income taxes?

b. What is Trident’s effective tax rate on a globalbasis (total taxes paid as a percentage of pretaxprofits)?

c. What would be the impact on Trident’s EPSand global effective tax rate if Germany insti-tuted a corporate tax reduction to 28%, andTrident’s earnings before tax in Germany roseto €5,000,000?

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Internet Exercises

1. Multinational firms and global assets/income. Thedifferences across MNEs is striking. Using a sam-ple of firms such as those listed here, pull fromtheir individual Web pages the proportions oftheir incomes that are earned outside their coun-try of incorporation. (Note how Nestlé calls itselfa “transnational company.”)

Walt Disneyhttp://disney.go.com/

Nestlé S. A.http://www.nestle.com/

Intelhttp://www.intel.com/

DaimlerChryslerhttp://www.daimlerchrysler.de

Mitsubishi Motorshttp://www.mitsubishi.com/

Nokiahttp://www.nokia.com/

Royal Dutch/Shellhttp://www.shell.com/

Also note the way in which international businessis now conducted via the Internet. Several of theabove home pages allow the user to choose thelanguage of the presentation viewed.

2. Corporate governance. There is no hotter topic inbusiness today than corporate governance. Usethe following sites to view recent research, currentevents and news items, and other informationrelated to the relationships between a businessand its stakeholders.

Corporate Governance Nethttp://www.corpgov.net/

3. Fortune Global 500. Fortune magazine is famousfor its listing of the Fortune 500 firms in the globalmarketplace. Use Fortune’s Web site to find themost recent list of which firms from which coun-tries are in this distinguished club.

Fortunehttp://www.fortune.com/fortune/

4. Financial Times. The Financial Times, based inLondon — the global center of internationalfinance — has a Web site that possesses a wealth ofinformation. After going to the home page, go tothe Markets & Funds Data page, and examine therecent stock market activity around the globe. Notethe similarity in movement on a daily basis amongthe world’s major equity markets.

Financial Timeshttp://www.ft.com/

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global financial enviornment

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